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Stock Return Dynamics Under Earnings Management


  • Xiaotong Wang


This paper explores how earnings management influences asset returns and return volatility via real economic activity. In the model, firms smooth earnings via the costly and economically suboptimal intertemporal transfer of assets and liabilities. As a result, the firm's stock return follows a process that conforms to an EGARCH-like statistical model. The key idea is that real earnings management generates an unobservable cost, and the market has to infer the underlying wealth of the firm from the smoothed reported earnings series. This framework may help explain why asset returns underreact to good news and overreact to bad news, while no news is always good news to the market. Empirical evidence that earnings innovations impact future return volatility, in line with the model's predictions, is found in the data.

Suggested Citation

  • Xiaotong Wang, 2005. "Stock Return Dynamics Under Earnings Management," Yale School of Management Working Papers amz2633, Yale School of Management, revised 01 Jul 2006.
  • Handle: RePEc:ysm:somwrk:amz2633

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    References listed on IDEAS

    1. Paul Gompers & Joy Ishii & Andrew Metrick, 2003. "Corporate Governance and Equity Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 118(1), pages 107-156.
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    12. Veronesi, Pietro, 1999. "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 975-1007.
    13. Timothy C. Johnson, 2001. "Return Dynamics when Persistence is Unobservable," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 415-445.
    14. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1995. "Investment analysis and price formation in securities markets," Journal of Financial Economics, Elsevier, vol. 38(3), pages 361-381, July.
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